How Effective Will Monetary Easing Be? The Bank Lending Channel and the Implications of Increasingly Internationalized Banks

As I noted in a previous post, monetary policy works through various channels, one of which is the “bank lending channel”. Lower policy rates, as witnessed in the past few months and shown below, should induce greater lending.

gb1.gifFigure 1: Nominal effective Fed Funds rate (blue), and real (red). NBER-defined recession dates shaded gray. Real Fed Funds rate calculated by subtracting lagged CPI-All 12 month change. Sources: Federal Reserve Board via St. Louis Fed FREDII, and author’s calculations. Note: sample period used in Cetorelli and Goldberg is 1980Q1-2005Q4.According to a new paper by Nicola Cetorelli and Linda Goldberg, presented at a recent Bundesbank conference, the magnitude of the impact depends on the degree to which the banking system is internationalized. While the usual tendency to associate financial globalization with the increasing internationalization of bond and equity markets, recent events have brought home the reality of the increasing internationalization of banks. From the introduction to Cetorelli and Goldberg:

Monetary policy transmission through banks has long been noted as one of the key channels for policy effectiveness. Seminal work by Kashyap and Stein (1994, 1995, 2000) shows that this lending channel differs across players within the financial system of the United States. While lending of small banks appear to be highly responsive to monetary policy shocks, the same is not true for larger banks. The main reason for the difference within the population — the authors argue — stems from the presumed greater ability of large banks to substitute reservable deposits with other external sources of funds, so that the shock to the liability side of their balance sheet from monetary policy is not transmitted to the asset side.

…We conjecture and show that this process of “globalization” of U.S. banking has had a deep and pervasive impact on the transmission mechanism of monetary policy. Barring truly global events, banks with activities in multiple countries can reallocate funds in the event of a liquidity shock occurring either domestically or abroad. Our argument thus presumes that banking organizations actively operate internal capital markets, in which the global banks move liquid funds between domestic and foreign operations on the basis of relative needs. Hence, according to this conjecture the shock to reservable deposits caused by a change in monetary policy would be absorbed through internal sources of funding rather than exclusively through an attempt to access external capital markets.

Our results also show that the total lending channel consequences of U.S. monetary policy are underestimated by a focus purely on U.S. markets. We look at the response of lending of the foreign offices of U.S. global banks to a change in domestic monetary policy and find evidence consistent with this the existence of an international mechanism of transmission of monetary policy. Hence, monetary policy through the lending channel may not be losing its effectiveness overall but rather it may be increasingly felt outside of the traditional field of observation. In this sense, our work directly compliments the Peek and Rosengren (1997, 2000) findings that banks are specifically involved in the international transmission of shocks. In our case, results based on bank-specific data demonstrate a direct mechanism underlying the type of monetary policy transmission across countries documented in analyses of macroeconomic data, as in Kim (2001), Neumeyer and Perri (2005), Canova (2005) and Goldberg (2005).

The differential between the impact of monetary policy shocks to bank lending in domestic versus international banks is highlighted in Table 3 from the paper.

gb2.jpgTable 3 from Nicola Cetorelli and Linda Goldberg, “Banking Globalization, Monetary Transmission, and the Lending Channel,” mimeo, May 19, 2008.[The results of this table are interpreted in the last paragraph of the empirics section:

…consider the counterfactual of an increase in the share of global banks by another 10 percentage points, to 75 percent of total domestic lending.

For a lower bound on this impact, we assume that total lending issued by nonglobal banks, large or small, has the sensitivity to monetary policy estimated for the large banks, at 0.13 percent, as in the numerical exercise described after Table 3. Total lending by non-global banks was about $1.8 trillion in the fourth quarter of 2005. Assuming a median loan growth rate of 1.9 percent, an increase in the Federal Funds rate of 100 basis points would reduce loan growth by about 7 percent, “shaving†loan growth by about $2.3 billion over eight quarters. If the share of total lending issued by global banks were instead 75 percent of the current $4.8 trillion, monetary tightening would have instead reduced lending by about $1.56 billion. While this is still the same 7 percent reduction in loan growth, it amounts to a 33 percent reduction in the amount of new lending that is affected by monetary policy through the lending channel.

section added 5/27]

In terms of the current situation, my interpretation of these results is that the loosening of monetary policy, at least as measured by the real Fed Funds rate, will have a smaller effect on domestic macro activity than otherwise, as global banks shift around funds between the parent firm and affiliates.

Note that while the expansionary impact of monetary policy on domestic activity is attenuated by this effect for international banks, the contractionary effect of monetary policy is also reduced, should the Fed raise interest rates to reduce inflationary pressures.

The results of this paper are consistent with the view that while loosening of US monetary policy might induce greater lending overseas by branches of US banks, thereby tending to support rest-of-world economic activity, they also imply that negative shocks to the assets of US banks will also tend to reduce lending abroad. Hence, deleveraging by domestic banks has global (or at least rest-of-OECD) implications. That means both negative and positive shocks will be propagated abroad. In this sense, I think decoupling of the major developed economies is even less likely to occur.

Originally published at Econbrowser and reproduced here with author’s permission.

5 Responses to "How Effective Will Monetary Easing Be? The Bank Lending Channel and the Implications of Increasingly Internationalized Banks"

  1. DC   May 28, 2008 at 9:57 am

    Under the "No Hedge Fund Speculator Left Behind" program, the Bernanke Fed is bailing out the bankrupt US Banking system with a "cheap money" monetary policy. Long term savers are punished and speculators are rewarded by a Federal Reserve that exclusively panders to the narrow economic interests of Wall Street Hedge Funds and financial banksters. From, estimated broad M-3 money supply is exploding to a hyperinflationary 18% annual rate. What we really need is a return to "sound money" policies to rectify the economic situation. What we are likely to get are further exploding commodity prices from the endless liquidity printed by the Fed. The US Dollar and economy are toast.

  2. akmi   May 28, 2008 at 3:39 pm

    Banking globalization’s dampening effect on monetary policy seems related to the carry trade. Inter-office lending and borrowing by non-Japanese banks and their branches accounts for most of the leveraged yen carry trade. When the fed cut interest rates during Q307-Q108, yen claims of foreign banks in Japan on their overseas branches declined. In 2004-2006, when the fed raised rates, the opposite occurred. When the USD/JPY (or other yen crosses) interest rate gap widens and the short- or medium-term currency outlook for a target country is appreciation versus the yen, the Japan branches of foreign banks lend yen to their branches outside Japan to take advantage of low Japanese interest rates and higher returns elsewhere.

  3. Guest   May 28, 2008 at 3:47 pm

    So financial globalization (particularly the globalization of banks, which rely on interest rates to guide lending) adds a counterweight to domestic monetary policy. When central banks wish to tighten money supply, they get partly the opposite effect as investors pile in to higher interest rates. When central banks wish to loosen money supply, some capital flees – effectively tightening the money supply somewhat – as banks prefer to lend at higher interest rates elsewhere.

  4. Guest   May 28, 2008 at 8:00 pm

    So if you are right we get the transmission of the US liquidity and credit crunch to other economies. That seems to be happening indeed.

  5. ononivwe ben   October 9, 2008 at 4:51 am

    the piece is fantastic.